FBIAS™ Fact Based Investment Allocation Strategies for the week ending 12/05/2014

The very big picture:

In the “decades” timeframe, we may still be in the Secular Bear Market which began in 2000 when the P/E ratio (using Shiller’s Cyclically-Adjusted P/E, or “CAPE”) peaked at about 44.  The job of Secular Bear markets is to burn off outrageously high P/E ratios over one or two decades, until finally the P/E ratio arrives back at a single-digit level, from which another Secular Bull Market can emerge.  See graph below for the 100-year view of this repeating process.

Even if we are in a new Secular Bull Market, market history says future returns are likely to be modest at best.   The Shiller P/E is at 27.3, up a little from the prior week’s 27.2, and approximately at the level reached at the pre-crash high in October, 2007.  Even though P/E’s are substantially lower than their crazy peak in 2000, they are nonetheless at the high end of the normal historical range and leave little if any room for expansion.  This means that the stock market is unlikely to make gains greater than corporate profit growth percentage, if that.  (note: all P/E references are to the Shiller P/E values, sometimes called PE10 or CAPE, which are calculated so as to remove shorter-term fluctuations; see robertshiller.com for details).

In fact, since 1881, the average annual returns for all ten year periods that began with a CAPE at this level have been just 3%/yr (see graph below).

This further means that above-average returns will be much more likely to come from the active management of portfolios than from passive buy-and-hold.  Although a mania could come along and cause P/E’s to shoot upward from current levels (such as happened in the late 1920’s and the late 1990’s), in the absence of such a mania, buy-and-hold investors will likely have a long wait until the arrival of returns typical of a Secular Bull Market.

In the big picture:

The “big picture” is the months-to-years timeframe – the timeframe in which Cyclical Bulls and Bears operate.  The US Bull-Bear Indicator (see graph below) is at 65.5, up from the prior week’s 63.3, and continues in cyclical Bull territory.  The current Cyclical Bull has taken the US and some of Europe to new all-time highs, but many of the world’s major indices have yet to top 2007’s levels.  The most widely followed international indexes, the Morgan Stanley EAFE Developed International index and the Morgan Stanley Emerging Markets Index, are both still below their 2007 peaks.

In the intermediate picture:

The intermediate (weeks to months) indicator (see graph below) is Positive and ended the week at 26, down 1 from the prior week’s 27.  Separately, the quarter-by-quarter indicator – based on domestic and international stock trend status at the start of each quarter – gave a positive indication on the first day of October for the prospects for the fourth quarter of 2014.

Timeframe summary:

In the Secular (years to decades) timeframe (Figs. 1 & 2 above), whether we are in a new Secular Bull or still in the Secular Bear, the long-term valuation of the market is simply too high to sustain rip-roaring multi-year returns.  In the Cyclical (months to years) timeframe (Fig. 3 above), all major equity markets are in Cyclical Bull territory.  The Bond market returned to Cyclical Bull territory as of February 28th.  In the Intermediate (weeks to months) timeframe (Fig. 4 above), US equity markets returned to Positive status on October 17th.  The quarter-by-quarter indicator gave a positive signal for the 4th quarter:  US equities were in an uptrend, while International equities were in a downtrend at the start of Q4, and either one being in an uptrend is sufficient to signal a higher likelihood of an up quarter than a down quarter. 

In the markets:

In a repeat of the prior week, markets with little dependency on commodities (especially oil) gained, while those with such dependency declined.  US markets gained an average of +0.2%, with the S&P 500 up +0.4% and the Dow Jones up +0.7% (the seventh straight week of gains for those two indices), but the Nasdaq 100 indexed slipped      -0.6%.  Canada’s TSX retreated by -1.8%, having given up all its earlier year-to-date lead over the US as a consequence of the slide in oil and other commodities.  Despite gains in some European indices, both the Developed and Emerging Market averages slipped for the week, -0.1% and -1.5% respectively.

US economic news was positive on balance, capped off by a blowout November jobs number (as long as you don’t read the “household survey” too closely, which was considerably less enthusing).  The Non-Farm Payroll (NFP) figure for November showed a seasonally adjusted gain of 321,000, the strongest month since January 2012, and the 10th consecutive monthly gain of 200,000+.  October’s figure was revised up to 243,000 and September’s to 271,000.  As economists had been expecting November’s figure to be in the 225,000 range, this was a large expectation-beater.  The unemployment rate was 5.8%, unchanged, though still at the lowest level since mid-2008.  For 2014, the economy is on track to produce the strongest annual payroll growth since 1999.  Average hourly earnings rose +0.4%, a solid gain, and are now up +2.1% year-over-year – closer to a level that will generate higher spending by wage-earners.

Canada, on the other hand, surprised with a negative November jobs report.  Employment declined by -10,700 in November after jumps of +43,100 and +74,100 the last two months, as reported by Statistics Canada. The unemployment rate rose to 6.6% from a six-year low of 6.5%.  The Canadian dollar, the “Loonie”, dropped to a 5-year low concurrent with oil dropping to a 5-year low, and few think it to be a mere coincidence.

In the Eurozone, the November Purchasing Managers Index (PMI) was reported to be just 50.1 vs. October’s 50.6, barely above the 50 dividing line between growth and contraction.  Germany was 49.5, a 17-month low, Italy clocked in at 49.0, Greece 49.1, and France 48.4 – all in contraction territory.  Ireland, Netherlands and Spain are bucking the trend and reported decent PMI numbers at multi-month highs, but they are by far the exceptions to the rule.  A composite reading that includes both new orders and the service sector was 51.1 vs. 52.1 in October, the lowest for the Eurozone in 16 months.

In China, HSBC Bank’s final reading on the November manufacturing PMI was at the flat-line of 50.0, a 6-mo. low and down from 50.4 in October. The services reading was 53.0 vs. 52.9. The government’s official manufacturing PMI was 50.3, an 8-month low, vs. 50.8.

By a wide margin, this year’s most important economic story has been the slide in oil prices, from a high this year of $107 down to the current $67 – a -38% decline that has had significant positive and negative consequences for countries, companies and people.  Many industry experts claim that booming oil production in the US – particularly from the spreading of fracking extraction techniques and from the shale-oil areas of the country – have been the major factor pushing prices down.  A look at a 30-year chart of US oil production tells the story:

Many high-yield bond investors have been wondering why their high-yield mutual fund and ETF holdings have been declining steeply for the past 4 months (now off almost 20% for many ETFs and mutual funds).  One non-obvious reason is that energy-related loans now comprise triple the share of the high-yield universe compared with just 10 years ago, and with falling energy prices comes a higher expectation of loan defaults from energy-industry borrowers.  This chart shows the steep rise in energy-related borrowers within the high-yield universe:

(sources: Reuters, Barron’s, Wall St Journal, Bloomberg.com, ft.com, guggenheimpartners.com, ritholtz.com, markit.com, financialpost.com, Eurostat, Statistics Canada, Yahoo! Finance, stocksandnews.com, wantchinatimes.com, BBC, 361capital.com, S China Morning Post, St. Louis Fed, Barclays)

The ranking relationship (shown in Fig. 5 below) between the defensive SHUT sectors (“S”=Staples [a.k.a. consumer non-cyclical], “H”=Healthcare, “U”=Utilities and “T”=Telecom) and the offensive DIME sectors (“D”=Discretionary [a.k.a. Consumer Cyclical], “I”=Industrial, “M”=Materials, “E”=Energy), is one way to gauge institutional investor sentiment in the market.

The average ranking of Defensive SHUT sectors rose to 6.5 from the prior week’s 7.5, while the average ranking of Offensive DIME sectors fell to 16.5 from the prior week’s 15.8. Institutional investors remain cautious, and the Defensive SHUT group continues to rank substantially higher than the Offensive DIME group ranking.   This caution is reflected in the fact that institutional investors are underperforming market averages this year, having been cautious and defensively positioned with lots of cash while market averages have gone on to new highs – leaving them behind.

Note: these are “ranks”, not “scores”, so smaller numbers are higher ranks and larger numbers are lower ranks.

Summary:

The US has led the worldwide recovery, and continues to be among the strongest of global markets.  However, the over-arching Secular Bear Market may remain in place globally even as new highs are reached in the US.

Because we may still be in a Secular Bear, we have no expectations of runs of multiple double-digit consecutive years, and we expect poor market conditions to be a frequent occurrence.  Nonetheless, we remain completely open to any eventuality that the market brings, and our strategies, tactics and tools will help us to successfully navigate whatever happens.